What Does Low Inflation Mean For Bond Owners?

If you’re like many people, you may pay a lot of attention to the day-to-day price movements of your investments. But to create and maintain an effective investment strategy, you also need to look at the big picture, specifically, the economic and market forces that can affect your investments’ performance. And one of those factors is inflation.

Of course, inflation has been fairly tame lately. In fact, some consumer prices fell through much of 2009, according to the Bureau of Labor Statistics. Will the mild inflation environment continue?

It’s risky to try to predict the course of any economic development. Yet some key signs point to continued low inflation. For one thing, unemployment remains stubbornly high.

Fewer people working means fewer people spending, which lowers the demand for goods and services. Also, we are currently not producing anywhere near as much as we could, given our productive capacity, according to the Federal Reserve (Fed). When this gap exists, the economy can typically expand without triggering higher inflation.

If inflation does remain low for the near term, the Fed is unlikely to raise short-term interest rates significantly; it typically raises rates in an effort to “cool down” an overheated economy.

Consequently, if inflation stays low, you may be looking at continued low interest rates, at least for a while. This would affect all types of investments, but it’s especially relevant to fixed-income vehicles, such as bonds.

Assuming short-term rates stay low for a while, what opportunities should you consider for your bonds? For one thing, you may want to expand your holdings beyond short-term bonds; longer-term bonds usually offer higher interest rates as compensation for inflation risk, which increases over time.

If interest rates do rise, however, the value of existing bonds tends to fall; no one will pay you the face value of your bond when newer ones are issued at higher rates. But because they have a long future stream of interest payments that wouldn’t keep up with current rates, long-term bonds typically adjust more than short-term ones.

To protect yourself against interest rate risk — the risk that your bonds will lose value if rates rise — you may want to consider building a ladder containing bonds of varying maturities.

When rates rise, you might be able to reinvest the proceeds of your short-term bonds into new ones that carry the higher rates. And if rates fall, you will still collect larger interest payments from your longer-term bonds, which would also typically fetch a premium price if you needed to sell them before they matured.

Keep in mind, though, that while a bond ladder may help protect you somewhat against interest rate risk, you need to consider other factors, such as credit risk or the risk that the bond issuer will default or be unable to make principal or interest payments, and market risk or the risk that you could lose some or all of your principal as the value of your bonds fluctuates. You can help combat these risks by considering quality, investment-grade bonds.

If it is suitable for your investment objectives, risk tolerance and financial circumstances, a bond ladder may help you prepare for changes in inflation and interest rates.

And by being prepared, you can avoid negative behaviors, such as hasty decisions and excessive trading, while you position your portfolio to help achieve your long-term goals.

Systematic investing does not guarantee a profit or protect against loss.

Scott Flake is a financial adviser with Edward Jones. He hosts a biweekly informal investment discussion on the second and fourth Tuesdays of each month at 10 a.m. at the Good Samaritan Society Majestic Rim, 310 E. Tyler Parkway. For more information, call (928) 468-1470.